What Is a 338 Election and How Does It Work?

Understanding a 338 election is crucial for businesses involved in mergers and acquisitions, as it can significantly impact tax liabilities. This tax provision allows the buyer of a corporation to treat the purchase as an asset acquisition rather than a stock purchase, offering potential benefits such as step-up in basis for assets.

This article explores the mechanics of a 338 election, examining its qualifying conditions, tax implications, and reporting requirements.

Qualifying Conditions

To initiate a 338 election, specific conditions must be met under the Internal Revenue Code. The buyer must acquire at least 80% of the voting power and value of the target corporation’s stock within a 12-month acquisition period. This establishes the buyer’s control over the corporation, a key aspect of the election process.

The transaction must involve a qualified stock purchase, as defined under IRC Section 338. The acquisition must be taxable to qualify, and the buyer must be a corporation, whether domestic or foreign, provided it meets the necessary criteria. The election must be made by the 15th day of the ninth month following the month of the acquisition date by filing Form 8023 with the IRS, formalizing the buyer’s intent to treat the stock purchase as an asset acquisition.

Tax Election Mechanics

The mechanics of a 338 election recharacterize a stock purchase as an asset acquisition for tax purposes. This involves a “deemed sale,” where the target corporation is treated as having sold all its assets at fair market value on the acquisition date. This step generates a step-up in basis, allowing the buyer to depreciate or amortize the assets over time, potentially reducing future taxable income.

The deemed sale can trigger tax liabilities for the seller due to the recognition of gain or loss on the sale of assets. Buyers must weigh these implications against the benefits of increased depreciation deductions.

A critical element of the 338 election is the allocation of the purchase price among the acquired assets, which must follow the residual method outlined in Section 1060 of the Internal Revenue Code. This method prioritizes certain asset classes, such as tangible assets and identifiable intangibles like patents and trademarks, before goodwill. Proper allocation can significantly affect the buyer’s financial statements and tax liabilities.

Allocation of Purchase Price

The allocation of purchase price in a 338 election requires careful planning to comply with IRS regulations while maximizing financial benefits. Section 1060 governs this process, requiring the purchase price to be allocated across asset classes, starting with cash and cash equivalents, followed by marketable securities, and then tangible and intangible assets.

For example, in a $10 million acquisition, $1 million might be allocated to cash, $500,000 to marketable securities, and the remaining $8.5 million distributed among tangible assets like machinery and intangible assets such as patents and customer lists. This allocation influences depreciation schedules, with tangible assets depreciated over their useful lives and intangibles amortized over 15 years.

A key consideration is the allocation to goodwill, the residual value after all other assets are assigned. Goodwill reflects the premium paid for the target’s reputation, customer relationships, and synergies. Its valuation impacts amortization and financial metrics like return on assets and equity. Companies must ensure goodwill valuation aligns with both tax and financial reporting standards, such as ASC 805, which governs business combinations.

Reporting Requirements

The reporting requirements for a 338 election demand precision to ensure compliance. Central to this process is the accurate and timely submission of IRS Form 8023, which formalizes the election. This form requires detailed information about the buyer and target corporations, including their Employer Identification Numbers (EINs), acquisition date, and transaction details.

Additionally, the buyer must complete Form 8594, the Asset Acquisition Statement, as required under Section 1060. This document outlines the allocation of the purchase price across asset classes and must be filed with the corporation’s tax return for the year the acquisition is completed. It is essential that both buyer and seller agree on the allocation to avoid disputes or IRS adjustments.

Types of 338 Elections

The 338 election framework offers flexibility through three distinct variations, each suited to different scenarios and tax implications: 338(g), 338(h)(10), and 338(i).

338(g)

The 338(g) election can be initiated unilaterally by the buyer, making it useful in cross-border acquisitions or situations where the seller’s involvement is not feasible. Under this election, the target corporation is treated as having sold its assets at fair market value, which may generate tax liabilities at the corporate level. However, the seller retains its original tax treatment for the stock sale, potentially creating a tax mismatch.

This election is often used in international transactions involving foreign subsidiaries. For example, a U.S. corporation acquiring a foreign subsidiary may use a 338(g) election to revalue the subsidiary’s assets, enabling higher depreciation deductions under U.S. tax rules. However, the deemed asset sale may subject the foreign subsidiary to local taxation, requiring careful analysis of international tax treaties and foreign tax credits to mitigate double taxation.

338(h)(10)

The 338(h)(10) election requires mutual agreement between buyer and seller and alters the tax treatment for both parties. This election is available for transactions involving an S corporation, a subsidiary of a consolidated group, or certain qualified subsidiaries. It allows the buyer to treat the transaction as an asset purchase while the seller recognizes it as a stock sale, often resulting in a single level of taxation at the shareholder level.

This election is advantageous in domestic transactions involving S corporations, as it avoids double taxation while providing the buyer with a step-up in asset basis. For instance, if an S corporation is sold for $5 million, the seller recognizes gain on the stock sale, and the buyer benefits from revalued assets for depreciation. The election must comply with IRC Section 338(h)(10) and address state tax implications, as not all states align with federal treatment.

338(i)

The 338(i) election applies to certain insurance companies and incorporates additional considerations unique to the industry, such as the treatment of policyholder reserves and other liabilities. It allows recharacterization of the transaction as an asset sale while ensuring compliance with tax and regulatory requirements.

For example, in acquiring a life insurance company, the 338(i) election may enable the buyer to revalue the company’s investment portfolio and other assets, aligning their tax basis with fair market value. However, the election requires attention to the treatment of reserves under IRC Section 846, as changes in reserve valuation can significantly impact taxable income. Buyers must work closely with actuaries and tax advisors to navigate these complexities and realize the intended financial and tax benefits.